Here is a quick update. First, this is not to be used as legal advice. Second, if you do live in the U.S. don't take this as a loss on your tax return. The max you can take on capitals gains/losses is only $3,000 anyway so save it for stocks or regular option contracts on an exchange. See your accountant beyond that as far as income reporting goes with binary options. I know that in Europe, there is no tax on this derivative at all. Lucky them. Isn't that why the U.S. left Europe in the first place?????
If you have made money or lost money trading binary options, there are going to be tax implications. This gets very tricky. There is no written law in the tax code regarding what to do if you are doing these kinds of trades with companies in Europe. The reason why I say Europe is because the broker I recommend people use if they are doing this is based there. Basically, foreign companies don't report to the U.S. government or any other governments around the world.
That means if you are a trader from the U.S. and make a net profit of $25,000 for the year trading binary options, technically the IRS is going to want to know about your increase in income. However, if you don't transfer it from your broker account into your bank account, there is not really any way for the government to know about it. The choice is up to the taxpayer on how they want to treat the money.
Let's say you are in the same situation, but have a net loss of $25,000 for the year in your binary option trades. If it is able to be treated as the same as vanilla options, then you can deduct up to $3,000 in losses. It is capped at $3,000 for the year.
All of these trades you do will be classified as short-term investments no matter where you are. That means if you do report to the U.S. government, then your net gains from trading activity would be taxed at the effective tax rate. That rate would depend on how much other income you had because there are different tax brackets in the U.S.
I know that in many European countries there is a flat income tax of around 30% that you pay each year on total income earned. Others have tax brackets as well. It all depends on where you live.
I think the main question here is going to be if binary options are classified as gambling (such as horse racing) or in the same way as regular options. I think the best way to determine that is to look at what they are. In most cases, the broker you are signed up with is going to offer you a certain amount of risk and an initial investment. They will either give you a return if you were able to make an in-the-money contract or take your entire investment if you are out-of-the-money. So technically it is an actual contract you are entering into and it is on a scale of a minute to a day or week and possibly month. But, if they are considered gambling then you can't deduct any losses. If you make $40,000 and then turn around and lose $40,000, there would be no tax effect. If you made $20,000 and lost $25,000, there is no tax effect. If you made $55,000 and lost $20,000, which is very common, then you would report $35,000 in income and be taxed at your effective tax rate. The rate varies on how much total taxable income you have for the year.
My opinion is that this is going to follow the same tax laws that are attached to regular options. That means net gains are taxed at your effective tax rate and net losses are deductible up to $3,000.
For example, if you do 100 trades during the year and it ends up netting you -$2,500 and you had no other investment activity going on at all, then you can reduce your taxable income by $2,500. I would not let this deter you from trading because if you make money, paying taxes on it is no big deal because you are making money. If you are worried about taxes then don't even trade in the first place.